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My last blog post was about how, as a result of a change in the Internal Revenue Code (the “Code”), the IRS will be altering the manner in which it audits many partnerships (and limited liability companies that are taxed as partnerships under the Code). In a nutshell, for tax years beginning on or after January 1, 2018, the IRS may assess a tax deficiency against certain partnerships rather than flowing the taxable income adjustment at the partnership level through to the individual partners and then collecting the additional tax from each individual partner. This change in the Code was deemed to be a revenue raiser due to the increased efficiency in assessing the tax against the partnership rather than the individual partners. This streamlined partnership audit process is similar to the IRS being permitted to settle an IRS audit involving tax-exempt bonds with the issuer or conduit borrower rather than having to assess a tax deficiency against the various bondholders and collecting the tax from each individual bondholder. This got me thinking . . . what happens if the issuer or conduit borrower and IRS cannot agree to a resolution when the IRS believes the tax-exempt bonds are taxable?

On November 21, as most of us were preparing for a relaxing Thanksgiving holiday, the IRS publicly released two internal guidance memoranda (both available at TEGE-04-116-0028) addressed to “All TE/GE Examiners,” the first of which describes new procedures for the preparation and issuance of IDRs in connection with tax-favored bond audits and procedures for the enforcement of responses to those IDRs, and the second sets forth IDR “Best Practices.” The announcement of the new procedures on the IRS website describes their purposes:

“The updated process will:

Provide for open and meaningful communication between the IRS and taxpayers.

Reduce taxpayer burden and provide consistent treatment of taxpayers.

Allow the IRS to secure more complete and timely responses to IDRs.

Provide consistent timelines for IRS agents to review IDR responses.

Promote timely issue resolution.”

A review of the new procedures, however, gives the clear impression that they are primarily designed to provide IRS agents increased leverage to force issuers and their counsel to respond more quickly to the often lengthy and burdensome IDRs that the IRS has been lately issuing, while imposing no pressure on the IRS to resolve audits more quickly.

‘I meant by “impenetrability” that we’ve had enough of that subject, and it would be just as well if you’d mention what you mean to do next, as I suppose you don’t mean to stop here all the rest of your life.’

‘That’s a great deal to make one word mean,’ Alice said in a thoughtful tone.

‘When I make a word do a lot of work like that,’ said Humpty Dumpty, ‘I always pay it extra.’

‘Oh!’ said Alice. She was too much puzzled to make any other remark.

‘Ah, you should see ’em come round me of a Saturday night,’ Humpty Dumpty went on, wagging his head gravely from side to side, ‘for to get their wages, you know.’[1]

Rick Weber of Norton Rose Fulbright is the Editor-in-Chief of The Bond Lawyer, NABL’s quarterly journal. He writes a wonderful column on language that introduces each issue, and in the Summer 2016 issue, he posed the following question: When issuers are required to pay arbitrage profits earned on investments of tax-exempt bond proceeds to the federal government, why is it called “rebate,” when the arbitrage profits were not the federal government’s money in the first place? “In order to have a “return” or “refund” or “pay-back” of funds to the US government,” Weber notes, “the funds must start there.” We venture an explanation below.

(Before we begin, a hearty “thank you” to our retired partner Jack Browning, who remains a boundless source of knowledge and wisdom, the elucidator-in-chief of hopelessly opaque topics like single family mortgage bonds, and a dear friend, for collaborating with me on this effort.)

These days, there are literally a million examples of words in the dictionary that mean the opposite of what they originally meant. “Rebate,” as used in this context, is one of them. What we now call “rebate” was once the payment of excess earnings on investments of tax-exempt single family mortgage bond proceeds that issuers made to the federal government instead of giving mortgagors a rebate on their mortgage interest payments.

Like me, at some point in your childhood, you were probably told not to “look the gift horse in the mouth.” After reading this blog post, the same could be said to me. We have written in great detail (see here, here, and here) about the increased flexibility afforded issuers by the recently promulgated Final Treasury Regulations governing, among other things, allocating proceeds of tax-exempt bonds and other sources to projects that involve both qualified and private uses (the “Allocation and Accounting Regulations”). The Allocation and Accounting Regulations permit “qualified equity” to be allocated first to private business use and then to governmental use. As discussed in the prior posts, “qualified equity” is essentially defined as amounts other than tax-exempt proceeds. However, there are timing and other restrictions on what is eligible to be considered “qualified equity.”[1] These restrictions have led to an inconvenience that is the topic of this blog.

The reimbursement window is larger than the qualified equity window

Qualified equity includes amounts other than proceeds of tax-exempt bonds that are spent on the same eligible mixed-use project as the proceeds of the applicable bonds. To be spent on the same eligible mixed-use project, the qualified equity must be spent pursuant to the “same plan of financing.”

The preamble to the Allocation and Accounting Regulations says that qualified equity is spent under the same plan of financing if

the qualified equity is spent on capital expenditures of the project no earlier than the earliest date on which the expenditure would be eligible for reimbursement were the bonds from which the proceeds are derived issued as reimbursement bonds . . . .”

The rule, as enunciated in the preamble, makes perfect sense. However, the actual language of the rule in the Allocation and the Accounting Regulations says that qualified equity is spent under the same “same plan of financing” if

the qualified equity pays for capital expenditures of the project on a date that is no earlier than a date on which such expenditures would be eligible for reimbursement by proceeds of the applicable bonds under [Regulations] 1.150-2(d)(2) . . . .”

Regulations 1.150-2(d)(2) says that a reimbursement allocation must be made not later than 18 months after the later of (a) the date of the original expenditure or (b) the date the project is placed in service or abandoned, but in no event more than 3 years after the original expenditure is paid (collectively, the “Reimbursement Period”).

If you are reading this blog, you may know that there are certain expenditures that are eligible to be reimbursed even though they were paid before the Reimbursement Period began. Specifically, a de minimis amount of pre-Reimbursement Period expenditures may be reimbursed as well as a certain amount of preliminary expenditures. Therefore, the window of time during which qualified equity can be used to finance a project begins after the period of time that expenditures would be eligible to be reimbursed under the reimbursement rules!

In reality, this discrepancy is less significant than it may initially seem. As discussed in the previous paragraph, the pre-Reimbursement Period expenditures are eligible for reimbursement even though the amounts paid to finance such expenditures are not eligible to be qualified equity. Therefore, a reimbursement allocation could be made on or after the issue date and the issuer could be reimbursed for the amount of equity that it used to finance the pre-Reimbursement Period expenditures. The issuer could then contribute the equity made available by the reimbursement allocation to finance a portion of the mixed-use project. Because the equity contribution occurs within the Reimbursement Period (assuming the mixed-use project has not yet been placed in service), it is contributed pursuant to the same plan of financing.

[1] As a technical matter, the restrictions do not preclude amounts other than tax-exempt bond proceeds from being qualified equity; rather, the restrictions prohibit the qualified equity from financing a project under the same plan of financing.

Even before the advent of P3s (public-private-partnerships), it was not uncommon for a governmental entity or a 501(c)(3) to enter into a joint venture with a for-profit, taxpaying entity. Sometimes these joint ventures take the form of either a state law partnership or a state law limited liability company (“LLC”). Most LLCs are taxed as partnerships for federal income tax purposes, which generally means that they are pass-through entities. In other words, the partnership itself does not pay tax on its taxable income (like a corporation would). Rather the taxable income flows through to the partners who are required to pick up their respective distributive shares of the partnership’s items of income and loss on their own separate federal income tax returns.

What would a Clinton or Trump presidency mean for tax-exempt bonds? Both candidates have declared a desire to change our tax system, but will this mean any changes to the tax-exempt bond rules? Neither candidate has expressed a desire to change how the tax-exempt bond rules work, but their other policy goals may have an indirect impact on the market.

As reported several times in this blog (here, here, and here), Rev. Proc. 2016-44 significantly expands the opportunities for management/service contracts that don’t result in private business use. One such post was Joel Swearingen’s very thoughtful piece on the future of the facts and circumstances test as applied to these contracts (here). Of course, Rev. Proc. 2016-44 retains the prohibition against any portion of the manager’s compensation being based on net profits, as that rule is set forth in the Treasury Regulations (specifically Treas. Reg. 1.141-3(b)(4)(iv)), so the IRS cannot override that rule through a Revenue Procedure. Unfortunately, in restating this prohibition, the IRS has muddied the water as to its boundaries, creating potential need for application of the facts and circumstances test. Please read on for a discussion of the questions that have been created.

Revenue Procedure 2016-44 is laudable because it significantly expands the scope of management contracts that can satisfy the safe harbor from private business use of facilities financed with proceeds of tax-advantaged bonds. It also makes much more feasible the use of tax-advantaged bonds in public-private partnership arrangements. Revenue Procedure 2016-44 does, however, effect one curious change of uncertain implication from its predecessor, Revenue Procedure 97-13.

The management contract safe harbors set forth in Revenue Procedure 97-13 provide that the reimbursement by the “qualified user”[1] of direct expenses paid by the manager to unrelated parties is not treated as compensation of the manager under the management contract. Consequently, such expense reimbursement is not taken into account in determining whether the management contract satisfies a Revenue Procedure 97-13 safe harbor from private business use. The Internal Revenue Service held in Private Letter Ruling 200222006 (Feb. 19, 2002) and Private Letter Ruling 201145005 (Aug. 4, 2011) that the payment of compensation by the manager to its non-executive employees (in the case of the former private letter ruling) and to its employees that do not have an ownership interest in the manager entity (in the case of the latter ruling) was the payment of direct expenses to unrelated parties, the reimbursement of which would not be considered compensation under Revenue Procedure 97-13.

Revenue Procedure 2016-44 changes this result. The reasons for, and implications of, this change are not immediately evident.